Lease terms…go long or go short?

Globe St profiled a recent Moody’s Analytics study highlighting some of the interesting byproducts of the unprecedented industrial demand created by the e-commerce spike during the pandemic. First and foremost, landlords have been signing shorter leases to take advantage of inflating lease rates caused by the incessant demand. Of the metros studied by Moody’s, the average lease term shrank from the 36 month mark in 2017 - 2019 down to 29 months by the end of 2021. There was also a corresponding 22% increase in leases of 2 years or less. This phenomena matches a story I heard during a recent trip to Salt Lake City. In an unusual twist of logic, some buyers were intentionally leaving spaces vacant for 6 - 12 months in anticipation of capturing significantly higher rents in the months ahead. The market had been moving fast enough to make such a decision seem logical. If this behavior doesn’t signify an overheated market, I don’t know what does.

To the spike e-commerce demand, inflation is now rampant and most likely persistent for a while, causing the same rationale for shorter leases to be justified by a separate reason. Interestingly, even some tenants say they prefer the shorter leases as a way to hedge against a potentially cooling off period caused by either oversupply or a recession. Perhaps they see an opportunity for lower rents and better space if this whole episode comes to a crashing end. Such an outcome feels far-fetched based on the way e-commerce has changed our consumer patters in an enduring way. Tenants may be able to hold out and find the rents they one day seek, but likely in a suboptimal space.

For landlords, playing this short duration game poses it’s own set of risks. Would you rather milk the last nickel of lease rents or lock tenants into longer leases that might bridge the gap over a potential market recession? At least the later puts you in a position to have a conversation with a tenant (even if they’re struggling to make rent) as opposed to desperately find new tenants after your short-term lease rolls.

In the last few days, the Fed came out with gloves swinging on their battle with inflation. Between talks of multiple 50 bps rate hikes at their upcoming meetings and meaningful balance sheet reductions, the accommodative stance to placate market volatility is suddenly gone. This means we will likely see rockier days ahead as the chances of a recession from an overshoot on Fed policy become higher by the day. With this murkier outlook ahead, the question of short vs long-term lease duration is no longer as simple as making decisions around the prospect of never-ending rent growth. The downside scenario has now fully arrived.